When prudence is at a premium

It was a moment that said so much about
QBE Insurance Group
’s tin ear to criticism.

For a decade, governance advisers and fund managers had held misgivings about the management structure at the top of the global insurance giant. Its former long-standing chairman,
John Cloney
, was not seen as independent as he had previously spent 17 years as chief executive.

Some say he may as well have been joined at the hip to
Frank O’Halloran
, the insurer’s previous CEO who himself had been entrenched in the C-Suite for nearly three decades.

Such longevity at the top had been feted as a steady and experienced hand that helped drive QBE’s long-running success. But as margins contracted and capital began to look weak, perceptions grew that the board lacked independence and fresh thinking was needed at the top.

This was the atmosphere when, in February last year, O’Halloran announced that after 14 years he would step down as chief – but would join the board as an independent director.

“We believe his continued involvement on the board will be welcomed by investors," said new chairman Belinda Hutchinson in the announcement of the CEO succession. She was wrong.

The criticism from investors at having O’Halloran stay on was so sharp the company changed its mind and bid farewell to the man who just two years earlier had been inducted into the International Insurance Hall of Fame. His successor John Neal made it clear he was none too happy to have his old boss hanging around.

And Neal had good reason to want a clean break. Six months after he took the helm, he is having to use all his might to change QBE’s track. Dividends have been slashed, hundreds – potentially thousands – of staff will be laid off and fresh acquisitions are off the agenda.

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Despite its problems, QBE remains a rare Australian success story as a business that has thrived overseas. It has become one of the world’s largest insurers, thanks largely to O’Halloran’s expansion strategy. But the final chapter on O’Halloran, once lauded as a genius, is being rewritten.

Like the Roman Empire, QBE has been a victim of its own success. Its operations across five continents grew too large to be administered from the CEO’s office on level two of its plain, dark headquarters on Sydney’s Pitt Street – a building that no one much liked but O’Halloran loved and refused to leave.Steady profit growth meant the market gave O’Halloran free rein to make as many acquisitions as he liked. Incredibly, no one outside the business knows how many he took over; it could be 70, or twice that.

He had a reputation for “never paying too much" but it’s difficult to put that claim to the test. Some analysts complained about a lack of information. A great unknown was how much profits were pumped up with money set aside for insurance claims and how profitable its new businesses really were. Some observers likened QBE to a “black box".

Much of QBE’s current woes can be traced back to the insurer’s foray into the US. The insurer entered in a major way in December 2006, following the $US800 million acquisition of Praetorian Financial Group from Hannover Re. The business, which at the time included 37 specialist property and casualty insurance programs and retail agency business, was touted to add $US1.4 billion in gross premium income to the group. QBE’s next major deal came a month after, when it paid $US1.16 billion for property and casualty insurer Winterthur. Others followed, including the $US275 million buy-up Renaissance Re’s US insurance operations in 2010.

It was a time when shareholders gave their tick of approval to O’Halloran’s aggressive acquisition strategy. But cracks started to appear - margins began to decline. As the global financial crisis unfolded and interest rates dropped reported insurance margins across the group fell from 22 per cent in 2007 to 7 per cent by 2011. QBE’s share price plummeted from a high of $35.19 in September 2007, to close at $13.67 on Friday.

Morgan Stanley analyst Daniel Toohey wrote in a research note last March that QBE’s global acquisition model was “distinctive in its leverage to the interest rate cycle".

“With around a third of QBE’s earnings coming from yields on its investment portfolio [and] with rates falling dramatically, its insurance margin has suffered."

Problems festered. Some claim QBE suffered from an internal culture that put O’Halloran on a pedestal while those with concerns were ignored. According to one QBE watcher, problems were emerging in one of the insurer’s European business but raising the issue with O’Halloran was effectively taboo. In 2009, Martin Lawrence of Risk Metrics, the corporate governance advisory, recommended investors vote against QBE’s remuneration report. O’Halloran’s termination package which Lawrence calculated at over $7 million, was “excessive", he said.

Cloney issued an ASX statement calling Risk Metrics’ report “jaundiced", even though QBE simultaneously announced it would cut the size of O’Halloran’s golden handshake. It marks the only time that a chairman of a public company used an ASX statement to take on a proxy adviser firm. One fund manager who had numerous run-ins with QBE over its lack of independent oversight, said their attitude could be summarised as: “they don’t give a shit".

But eventually QBE had to start paying greater attention to critics. It issued two profit downgrades last year following a spate of natural disasters, including an earnings downgrade as losses from superstorm Sandy mounted.

Meanwhile, QBE’s crop cover business faced claims from one of the worst droughts in US history. It is also facing lawsuits over its lender-placed insurance products, while a slow recovery in the US economy had affected the rates and sales volume of its LPI arm.

QBE has been undertaking serious remediation measures – including the deliberate shedding of inadequately priced risks – across its problematic US division. But the explosive cocktail of losses, past claims and remediation measures culminated in a $US237 million loss for the US division in 2012. “It was a case almost of Australians thinking they knew [the US] business well," one fund manager who declined to be name said.

Neal admitted that the US division was the “problem child", and that management was doing all it could to steer QBE’s biggest division back on profitable track.

Tough decisions were made to improve the business – one of which was to slash the dividend payout ratio. Investors reacted angrily to the dividend cut, but many also said they respected Neal’s decision. Equity Trustees portfolio manager Zia Rahman said he would rather QBE cut dividends than dilute shareholders’ holdings through a capital raising.

“The UK, Australia . . . they have been good. The growth in the US has been the biggest issue,"Alphinity Investments principal Andrew Martin, said.

It is undeniable that O’Halloran played a vital role in shaping QBE’s fortunes today. It is important to give kudos to O’Halloran, who is today the chairman of broking group Steadfast, for propelling QBE on to the global map. QBE underwrote around 17 per cent or $760 million of the insurance Steadfast sold in 2011. O’Halloran received $US11.5 million in remuneration from QBE in 2012, including a $7.4 million termination benefit, according to the latest annual report.

QBE’s biggest shareholder, Aberdeen Asset Management, recently said the company would not water down O’Halloran’s severance pay of $2.34 million plus incentives, as he now chairs one of QBE’s largest customers.

Neal has made it clear that acquisitions was not on the company’s immediate agenda, as the group takes a hard look at its business and improves its portfolio.

QBE had also commissioned an independent audit to understand shareholders’ perception across the group, while Neal has vowed to improve QBE’s communication with shareholders. It’s widely agreed that things are not so bad at QBE that the company cannot be put back on the right path. It’s also widely felt that that path will be different from the one pursued by O’Halloran.

In a rare media interview, the long-time chief told AFR’s Boss magazine in 2009 of his philosophy about managing risk: “I’m a very careful man," O’Halloran said. “I always make sure the lights are switched off; double check the locks on the door . . . and drive at least two car lengths behind the car in front. Then you’re driving along one day and something happens you don’t expect – like a meteorite falls out of the sky and lands on top of the car."

Just like that meteorite, Frank O’Halloran has been brought down to earth.